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Economics in Two Lessons

May 16th, 2015

I’ve been promising for a long time to write a new book, framed as a reply to a free-market tract Economics in One Lesson by Henry Hazlitt, published in 1946, but still in print and popular among free market advocates. Its popularity reflects the fact that it’s a reworking of Bastiat’s “What is Seen and What is Not Seen”, still one of the best statements of the case for free markets.

Bastiat’s argument is implicitly based on the concept of opportunity cost but, since the term wasn’t coined until 1914, he doesn’t use it. Neither, more surprisingly, does Hazlitt. Once this is made explicit, Hazlitt’s rather ponderous, and misleading statement of his “One Lesson”

The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups.

can be boiled down to the much simpler statement “Market prices reflect opportunity cost”. In important respects, this is true, particularly when we consider the problem from the perspective of choices about how to allocate an individual, family or government budget. With fixed aggregate levels of public expenditure, for example, more money for the military means less for schools, and vice versa.

There are plenty of other questions about private and public decisions for which Hazlitt’s One Lesson is useful. Another example is the well-supported finding that the best way to fight poverty is to give money to poor people. This is unsurprising given that poor people themselves will usually have a much better idea of the opportunity costs they face than will those seeking to help them.

But as a general statement, Hazlitt’s One Lesson is false, which is why my working title is Economics in Two Lessons”. Lesson Two is “Market prices do not reflect all the opportunity costs we face as a society”

To someone trained in mainstream economics, as I have been, the immediate examples of this Lesson are “market failures”, such as externality, monopoly and information asymmetries. I originally planned my book to focus on these market failures, making it a somewhat idiosyncratic take on what is usually called public economics. But I kept feeling that I was missing out too much that was important: unemployment, income distribution and many other issues.

After struggling with this for a long while, I reached the conclusion that a framing in terms of opportunity cost worked to deal with the issues with which I was most concerned, and allowed for a more fundamental critique of the free market position. My central point is that, before we even consider whether a set of market prices is subject to market failures in the usual sense), it is necessary to consider

* The allocation of property rights, broadly defined to include rights to pensions and social security, obligations to pay tax and so on, and the opportunity costs associated with alternative allocations

* Whether the market outcome is a full employment equilibrium or a recession/depression. In the second case (very common, as I will argue), markets don’t properly match supply and demand, so that prices and particularly wages do not determine opportunity costs in general.

My recent posts about the nature of property reflect some of my thinking on the first point, and I’ll soon be posting about the second also. As with Zombie Economics, though less systematically, I’m planning to put up draft extracts from the book for comment and criticism.

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  1. John O’Connell
    May 16th, 2015 at 18:42 | #1

    You may find “Deductive Irrationality: A Commonsense Critique of Economic Rationalism” ed. by Stephen McCarthy and David Kehl useful and interesting on Locke, Smith, Marshall, Keynes, Hayek, rational expectations etc. Also, Skidelsky has published a Penguin “The Essential Keynes” which is very convenient containing writings not easily accessible (but is too short).

  2. John Quiggin
    May 16th, 2015 at 19:05 | #2


  3. Mick
    May 16th, 2015 at 19:07 | #3

    Looking forward to a bit of rigorous political economy.

  4. Ikonoclast
    May 16th, 2015 at 19:21 | #4

    “Market prices reflect opportunity cost.”

    This is an ideological statement, not an empirical statement.

    It would be more accurate to say;

    “Market prices reflect of a multitude of irrational and incomplete assessments of opportunity costs.”

    Sometimes such answers can be roughly “right” even though every individual assessment is wrong… and sometimes such answers can be just wrong, for example when ignoring a severe negative externality due at an indeterminate time in the future.

  5. Ikonoclast
    May 17th, 2015 at 09:22 | #5

    My above reply was not well thought out. I am the first to admit it. It does reflect a general unease I feel about the market price / opportunity cost equation or correlation.

    I have the uneasy feeling that “Market prices reflect opportunity cost” contains either a circular reference or an infinite regress reference.

    “In microeconomic theory, the opportunity cost of a choice is the value of the best alternative forgone, in a situation in which a choice needs to be made between several mutually exclusive alternatives given limited resources. Assuming the best choice is made, it is the “cost” incurred by not enjoying the benefit that would be had by taking the second best choice available.” – Wikipedia.

    I hope this is an accurate definition as I will use it. The first issue is the meaning of “cost” in this definition. Does it mean money cost or utility cost of a non-monetary form? “Cost incurred by not enjoying” sounds like a utility cost (the dis-utility of not enjoying something else.)

    It seems in all market decisions to purchase we are weighing up the utility of the item purchased and the dis-utility of not purchasing something else. We put a market price on utility. This is empirically provable because we actually pay the price when we purchase. We also implicitly put a market price on the utility of the second preference purchase. (If that price came down by x then I would prefer that product.) Thus the market price of the 2nd preference
    plays a role in our decision.

    In the above case this means that; “Market prices reflect Market prices”; a circular reference. Does this tell us anything essential and new about markets? There has to be another level to save the market from being totally self-referencing. I assume that level is both the cost of inputs and the physical-energetic feasibility of supplying the inputs. It is the latter which stops the market from being entirely self-referencing and anchors it in the real world. It’s the problem of the allocation of scarce resources which seems to be absent from the formulation “Market prices reflect opportunity cost”.

    The above thoughts might be all nonsense. I am not sure. Maybe I can be demolished on this.

  6. Newtownian
    May 17th, 2015 at 12:27 | #6

    Sounds interesting. I wish you well.

    Indeed I wonder John if you will be tackling in effect the hard general question, that continually bugs me, of to what extent Economics is a hard science v. an art – a noble product of the Enlightenment with laws as deeply rooted in the fabric of the universe aimed at bettering the state of the world in general v. (put provocatively) the delusional product of a self-serving priesthood divorced from the real world, reminiscent of the medieval scholastics and their pinhead angels.

    I ask this sincerely. Though emotionally attached, like any good watermelon, to the second thesis option being predominant, my head and reading tells me the truth is very different. For example the economics concept of discounting indicates we as trapped in the present primarily with a quite short timeframe when its comes to planning for future changes. And recently I’ve encountered the long interest of economists (and lawyers) in causality which scientists and engineers only seem now to be recognising the significance of, thanks to the work of Daniel Pearl and colleagues. Conversely my gut and experience tells me too many strategic solutions proposed by environmentalists, engineers and ecologists to the problem of a sustainable economies are based on their ideas of how people should be or think, rather than the messy reality of how they behave and are constrained by day to day realities.

    Your interaction with Climate Change focused science policy managers (most will now be too old and senior to be actuall archetypal scientists) will have familiarized you personally with the differences between knowledge of current hard scientific method and world views and its differences with the perspectives of economists and economic methods which. And your previous book on post 2008 economics revisionism shows you well recognise something is rotten in Denmark. Thus you are probably one of the best placed people today to address my question, or at least compare and contrast the world views arising and identify the knowledge/conceptual gaps.

    Personally, from dabbling at this intersection (from the opposite direction of professional environmental science interest in the implications and fear/discovery that my superannuation is grounded in feet of clay) I perceive you may be taking on a frighteningly challenging project.

    Nevertheless I’m still very pleased to see you are looking at among other things
    – the issue of private property which is central to understanding money and power and how these are at bottom rubbery social contracts founded in human inter-relationships rather than solid lumps metal found in Scrooge McDuck’s money bin – the latter habit of thought I think the majority still cling to including me.
    – the relationship of ‘externalities’ and other realities to economic theory, how we should use the latter to relate to the former and how acceptance of the market as the dominant driver of social development is madness.

    Good luck.

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